Is the Office Building Dead?

The only thing constant in life is change and so it goes with the “Office Building.” What was an immutable truth 20 years ago is yesterday’s news in today’s globalized, digital, warp-speed economy. So, are office buildings—a key food group of the commercial real estate universe—dead or dying? With nearly 11 billion square feet of office space in America, this is a trillion-dollar question.

As an investor in multiple office buildings and an owner of a firm that manages $300,000,000 worth of other people’s office and retail buildings in the Central Valley of Northern California (Modesto, Stockton, Manteca, Tracy, Sacramento, ElK Grove, Merced, etc.), we think about this question a lot. We have ours and client’s money at stake. On the one hand, there are some great buys in this category. In our area, you can still sometimes buy office buildings for under $100 per square foot. At the same time, this is an area with chronic vacancy and office tenants can be hard to come by.

ARGUMENT 1: THE OFFICE BUILDING IS DEAD!

Four drivers of the slow and painful death of Office Buildings:

Office Buildings are Grossly Inefficient:

Why do people need to drive someplace so they can sit in the same area with other people and type on their computers and talk on the phone. This inherently does not make sense as an activity. As long as good performance metrics are in place then people can get about the same amount of work done from home or in a coffee shop and they will be happier because their jobs better fit into their lives.

Office Buildings are Too Expensive:

Rents are $1-$3 per square foot per month. For a 2,500 square foot office space this could easily cost $4,000-$7,000 per month. This is for a relatively small operation. If this work could happen outside of a formal building then why spend the money. That money could be much better spent on hiring people or increasing profitability.

Co-Working is Growing Quickly:

The rise of companies like Regus, We Work and dozens of other large and small companies has led to a much more efficient use of office space. Independent workers and small companies do not have to make large space commitments, they use exactly what they need. JLL reports that co-working space has grown at an average annual rate of 23% since 2010.

It has only been one generation since people communicated with inter-office mail and documents were produced on a typewriter. When the fax machine came into common business usage in the 1980’s it was a game changer. Today we can do a video conference on a phone and sites like Go To Meeting have made product demos and multi-location virtual meetings common. Gone are the days when everyone had to sit at a table in a suit and tie to communicate. Large, well-capitalized companies are working hard to create technology that changes how business is conducted and allows business to be done seamlessly from more places.

Commercial Property Management Stockton CA

As the chart above shows, office vacancy has stayed relatively high, generally at or above 10%. This is largely due to an eroding value proposition for office space. It is expensive to create but the utility is mixed. Those dollars may be better off building apartment buildings or stand-alone Burger King restaurants.

ARGUMENT 2: OFFICE BUILDING HAVE AN IMPORTANT FUTURE!

Five reasons Office Buildings will not go away and are, in fact, being reborn:

Humans are Social Animals:

Computers have not taken over the world yet and are unlikely to do so during our lifetimes. Humans want to spend their time on valuable endeavors and with people they like. If they are going to spend most of their waking hours doing something then it should be fulfilling. Humans are evolutionary programmed to run in packs. It was safer 10,000 years ago and it still feels safer today. Working in an office with a group builds morale and reinforces stability and a complex social structure. We work in offices for the same reason we check our Facebook accounts. We are tribal by nature and want to be around our tribe.

Business is Very Competitive:

Eighty percent of businesses go out of business in their first five years for a reason: business is highly competitive. Someone else is always out to eat your lunch. To win in today’s economic climate you had better invent a purple cow (to quote Seth Godin). Your product had better be unique, creative and valuable. These types of ideas, and executing on them, requires great ingenuity and diligent execution. A world class football team can not play their game in a Starbucks. They need to be on the field together and running in formation. This sort of organization happens in an office. Ideally it happens in a cool office with great furniture, signage, branding and technology.

Customers Evaluate You in the First Thirty Seconds:

Half of any business is creating income and this means selling. Selling involves presentation and appearance. A company’s website had better look great but customers will also want to meet in your office. They want to see your team. They want to know if they can trust you to do what you say that you and your product will do. The core currency of business is trust and risk-management. Having a physical location that is presentable tells customers that you are legitimate. It is hard to do big business while working out of your parent’s basement.

Office Space is Consistently Full:

Look at the CoStar charts above. Even though office space has a higher vacancy rate than other property types (retail and industrial), it stays fairly constant full. It has not dropped off a cliff. In fact, older, class- C office space stays very full with an average of 5%-7% vacancy. This is because it is more affordable. A relatively inexpensive new paint job can make any building look better quickly. Only the best and most profitable companies usually need, and can afford, class-A office space. Most people drive Hondas even though they would like to buy a Tesla.

Co-Working is Bringing Independent Contractors Back to the Office:

A recent NPR poll recently found that 1 in 5 US workers is a freelancer or independent contractor. This is a dramatic shift in how American workers work. Gone are the days of lifetime employment and pensions. Many US workers now must act entrepreneurially and much of this can not be done from a coffee shop or back bedroom. Workers are more productive when they get dress, go to an office, and dedicate themselves to a central focus for many hours. Co-Working spaces are filling this growing need and providing independent workers and small companies a flexible place to operate their business in an efficient, presentable and professional environment. The JLL article reference above also points out that among the most common co-working clients are 30 something men that work for large companies.

SO, ARE OFFICE BUILDINGS DYING? WHEN IS THE FUNERAL?

Conclusion: Betting on the death of office buildings is a mistake but there is continued pressure on the category to grow and adapt. Companies will continue to change in how they use buildings and work to use them more efficiently. That means that as an investor, asset manager or commercial property manager, it is your job to be on the right side of the trend. It is likely that 9%-12% chronic vacancy will persist and that will keep rents lower than they might otherwise be. I am amazed that there are 11 billion square feet of office space in America and that about 10 billion of it is occupied. Given that there are 350,000,000 Americans, that means that each man, woman and child could have 31 square feet. That seems like a lot. More surprising is that new office towers continue to rise in our major cities. One key takeaway is that, with 10 billion square feet are occupied, 1billion is not. Your job is to avoid being in the vacant 1 billion square feet and also to know that tenants will use that vacant square footage as a negotiating tool. It is supply and demand. When tenant’s have options, landlords have to work harder and be more creative to keep tenants.

Below are NINE ways that you can make sure you are working on the right office building investments and keep them full with paying tenants.

In the markets where we work, the Central Valley and Northern California, our vacancy rates tend to be 3%-5% greater than the national average but, as the Bay Area continues to move our direction, we are seeing this trend shift. Manteca, Stockton, Tracy and Modesto are all seeing new businesses and employees moving into town and, as a result, rents have risen dramatically and vacancy rates have gone down. See the chart below. Vacancy rates have dropped in our region as the Bay Area has increasingly become unaffordable.

NINE WAYS TO KEEP YOUR OFFICE BUILDINGS FULLY OCCUPIED

Victories are won in the landlord wars through small efficiencies, successes and insights.

1. Start by Buying the Right Building—Location is the Key:

A great location can overcome a multitude of sins. The first rule in property investing is: “you make your money going in.” You are far better off paying a fair price for a great location than a great price for a fair location (to paraphrase Warren Buffett).

We look for assets in core locations with high visibility. This normally means buildings on hard corners, in central business districts, near freeways, and on high traffic streets. Tenant’s want great signage so that clients can find or hear about their businesses. We are big fans of the return to the downtown. In the 1970’s and 80’s, malls were built across America. The Vintage Faire mall in Modesto was built in 1977 and decimated our downtown. Very quickly it became a ghost town. Now we are seeing the reverse. Tenants want to be downtown. They want a more urban and authentic experience. Millennial’s want nothing to do with the mall. They are looking for an authentic experience and American downtowns provide this.

2. Concentrate your Efforts—Don’t Dabble:

As a commercial real estate investor or commercial property manager you should concentrate your efforts on certain areas. We manage or own more than a dozen buildings near downtown Modesto and the result is that we have active relationships with dozens of local tenants. We know them personally, have rapport with them and they are familiar with our systems and organization. This works great because as their needs change, we have the right space for them. Many times, we have had a tenant leave from one building we manage to go to another building we manage. The world is too competitive for dabblers. While diversification has its strengths, success is created through focus. When you are the smartest person in the world at a very niche piece of knowledge, nobody can beat you in that area. You can spot micro trends that nobody else sees.

3. Paint the Building with a Modern Color Scheme:

Paint is 5-10 mm thick and a mile wide. When a building gets a fresh paint job, it looks like a new building. Tenants, even in class C buildings, want to be in a clean fresh and modern environment. I am a huge fan of fresh paint. It is the fastest return on investment that you can have. I also enjoy the creative part of it. As a manager or owner, it is your job to recast the building, to position it in the best light possible. Getting this right takes practice. If I am honest, about 50% of the buildings I have painted have come out exactly as I have wanted and had that “Wow” effect, but I am getting better. The trick I have learned is that you have to match the paint job to the architecture. Putting a great color scheme on lousy architecture will not give you the look you want. We recently painted two side by side apartment buildings with the same color. One side had better architecture and the paint looked way better on it than the other side. Maybe this the “skinny effect” in that all clothes look great on skinny people (As I write this in the early morning, I should go jogging…).

4. Brand Your Building:

Give your building a name. Branded buildings have higher occupancy rates. When a building has more than just an address it is perceived as being more substantial. While certainly our 45th President has literally made a fortune on this idea, it also works in smaller market and smaller buildings. Giving your building a name and putting it on the signage works with tenants and helps to advertise your building. Branded buildings convey an identity and a story. They give a sense that history happened here. I have recently worked on buildings called the “Cook Marketplace,” and our office is in the “Pacific Center.” We recently branded an apartment complex “Graceada Paseo” and are painting it on the side of the complex to convey a Spanish theme. We are also working on a building that we are calling “101 McHenry” because it conveys that it is the start of a major street in Modesto.

Brand Your Commercial Building

5. No Jerk Policy:

We win big with our tenants by being empathetic and friendly while still being firm when we need to be. Tenants are not robots, they are people, working to operate viable businesses. When tenants move in, I and members of our team stop by as they are moving in to check in on them. Too many landlords are difficult people who build contentious relationships with their tenants. This is a bad idea. Being nice, without being a pushover is FREE. Finding new tenant and having chronic vacancy is EXPENSIVE. It can take more than a year of occupancy at a higher rate to make up for a few months of vacancy. Check your ego at the door and be helpful. This will make you money and reduce your tenant headaches.

You have to love what you do and the people you do it with. This does not happen all the time but you only get one life and you should do things that are important and meaningful. Your tenants, employees and co-workers will see this in you. I personally love the challenge of real estate. It requires me to be my best self. As I work with clients and partners and investors and I must bring both competence and empathy. The market moves in cycles and there are ups and downs. The people I work with are looking to me (and my business partner and our team) to pilot that ship through the ups and downs and get where we need to go.

6. Make a building video. Give it a website. Put it on social media:

The internet sells for you while you sleep. Tenants are trying to figure out their businesses in the middle of the night and googling around and that is your chance to shine. Interview your tenants and put them on the website. A web page can be built inexpensively and if it gets you one extra month of rent from someone, then it is paid for. It is a great investment, especially for a larger building. As I have been writing more blogs, I have enjoyed seeing that people are reading this content while I sleep, on the weekends and while I am busy working on properties.They are getting a feel for our company and the work we produce. This can certainly be true for your property as well. We live in an amazing time and it is up to us to use the largely free tools at our disposal to get our message across.

7. Cultivate Tenant Relationships Now:

When you manage or own multiple buildings in a community you get to know the tenant population. They are always weighing their options. I see potential tenants at business events and kid’s soccer games. It is great to be friendly and tell them you would love to work with them someday.

8. Build a Village:

Everyone wants to be part of a community. We want to be insider’s and part of a cool group. Your building can be that. You are in the “shelter” business. Think about that—why do people come to buildings in the first place? They want a place, that is out of the elements where they can collaborate with others and get great work done. Your job is to provide a safe, productive and inspiring place where people can work on their various companies and missions. Why not create great communal space where people can gather? It is a challenge to do, but if you can create a place where tenants know and like each other then they will stay longer and the overall health of the property will be better.

9. Work with the Brokerage Community:

You usually get what you pay for. My experience is that paying professionals, and then managing them well is worth it. Brokers are in the business of knowing which tenants are moving where. They get paid to know who is doing what and they will have insights and leads that you won’t have. If you get your space filled a month or three earlier than you otherwise would have then their cost is free or minimal. As a broker and someone who has worked with brokers, having great brokerage relationships is a joy. The relationship can create collaboration and creativity that brings ideas to a project that were not previously imagined. Great brokers know the right people to talk to in tenant organizations and the angle to take. They know what those companies are trying to accomplish and how your building can fit within their mission.

We recently worked on a building where a former owner tried to attract a tenant by calling the company directly without results. We knew the right broker who had a relationship with that company and were able to land the tenant. We had to pay a significant brokerage fee for that but it was well worth it. Everyone has to make a living and paying the right professionals in the business will lead to greater results. At the same time, you cannot just list a building and check out. Brokers are busy. They have lots to competing interests on their time. It is important that you check in on them regularly and do your part of the work. This includes identifying potential tenants, opening up your rolodex as well and sometimes meeting potential tenants on site tours with the broker. I often work to make the job of the brokers that I work with easier. I want them to think of the buildings I am working on first when they have a tenant in hand. If they know that your building is likely the fastest path to getting paid then you will get more calls.

We live in an age when technology has changed the value proposition of both retail and office space. This has caused some traditional tenants to leave or change their format and new tenants to come in. In the end, my bet is that office space is here to stay but, like almost anything in business, the top 20% of the owners and managers experience 80% of the success so it is important that you choose be organized, have a plan and lead your office property to success.

Joe Muratore, CCIM is a Principal at NAI Benchmark, based in Modesto, California. They specialize in investment and commercial property management and manage more than $300,000,000 worth of commercial property in Northern California with a focus on the Central Valley and a concentration of buildings in cities like Stockton, Modesto, Sacramento, Merced, Turlock, Manteca and Tracy.